Inventory Declined

While it was not much the inventory levels at Cushing Oklahoma declined by -500,000 barrels last week and the first weekly decline since November. This could be a sign of things to come.

Cushing is the delivery point for WTI oil futures in the USA. It has a capacity of 71 million barrels. It was at 88% capacity the prior week at 62.2 million barrels. The drop in inventory levels probably meant Cushing quit taking in additional oil for storage because they were running out of room. It could also mean refiners were taking more oil from Cushing although the pipelines south run at a constant rate so that is less of a possibility.

Refiners consumed 16.1 million barrels per day of crude oil last week. That is just below the high for the year at 16.21 mbpd just two weeks earlier. Refinery utilization has declined slightly from that week from 92.3% to 91.3%. There are probably some refiners still in their maintenance cycle but that should end very soon. Refiners should accelerate to about 95% utilization by Memorial Day and the start of driving season.

They did supply a record amount of refined products to market at 19.58 mbpd last week. That is the high for the year but I expect that to exceed 20.0 mbpd in the coming weeks. Gasoline prices may have risen somewhat but they are still about $1 below year ago rates. Summer driving demand should be high.

The official reporting agencies, the EIA and IEA, are starting to predict sharply lower production later this year. I think they finally believe what they are seeing in the technical reports. Most E&P companies are still cutting rigs as contracts expire. Only one company I know is planning on adding rigs in June and July and that is Pioneer Natural Resources. If prices continue higher it could induce companies to start putting rigs back to work.

However, production will not increase for a long time because there are more than 4,000 wells in the fraclog that will have to be fracked and then put into production. That process should take 6-12 months because the service companies still have to keep up with the current wells being drilled and completed.

I think the hiccup in production that will occur over the next six to twelve months will raise prices significantly. Producers are not going to jump back into "frantic" production mode and will be more conservative for the next couple of years. For instance Whiting has cut rigs down from 25 to 11 and plans to complete only 77 wells the rest of the year compared to the 79 they completed in Q1. Factor that across all the other producers and there will be a real slowdown in production by 2016 that could last through 2016 since existing shale wells will deplete an average of 77% in their first year and another 50% in their second year. That means a well that came online at 1,000 bpd will only be producing 230 bpd at the end of 12 months and 115 bpd at the end of 2 years. Apply that metric to the 90,000 shale wells already producing and you get the idea about how fast production can decline.

Baker Hughes said they were no longer going to supply quarterly well numbers but in Q4 there were about 9,544 onshore wells drilled with the vast majority in the shale fields. Estimates for Q1 are in the 5,000 range and for Q2 in the 4,000 range. If you take that 9,500 number and multiple it by the prior 8 quarters you get about 76,000 shale wells that should have already depleted to roughly 10-15% of their initial production rates. With less than half the number of quarterly wells being drilled and only about 30% of those being fracked and completed the number of new wells actually coming on production could be in the 1,200-1,500 per quarter range.

Do the math with me. In Q4 roughly 9,000 wells went into production. If 5,000 wells were actually drilled in Q1 and only 30% were completed (1,500) that means quarterly initial production rates are going to decline by as much as 85% for Q2. That means a much lower addition to production to offset the roughly 75% decline in production from the 36,000 wells that went into production in 2014. I know, the numbers are staggering.

Even if producers begin to complete the more than 4,000 wells previously drilled and not completed it will take them 6-12 months to eliminate the fraclog. Assuming 1,000 per quarter in addition to the 4,000 wells currently being drilled per quarter and that is still only half the pace of completed wells we were seeing in Q4-2014.

To make a long story short we are not going to see production increase dramatically for a long time. I believe analysts and economists are going to be surprised at the production decrease over the next 12-18 months. Couple that with the increase in global demand because of cheaper fuels and we could be seeing oil back over $100 by the end of 2016. Supply and demand is a wonderful thing. The more supply the cheaper the product and the cheaper the product the more the supply declines and prices rise. Eventually the cycle repeats. Most of the oil majors have been through this cycle multiple times. They are more conservative on the upswing and are damaged less on the downswing. The companies that are getting hurt are the smaller shale producers that have not been through this cycle because the last one was in 1998 and shale was not even a buzzword back then. The financial crisis gave them a taste of a cycle but it was very short lived so the pain was manageable.

In 1998 the price of oil declined to $10 and the well count fell to 488. The cause of the decline was Saudi Arabia trying to flood the market with oil and force other OPEC members to conform to the quotas. Saudi Arabia was successful and prices rose for the next ten years. The current crisis was caused by Saudi Arabia refusing to be the only OPEC member to cut production and vowing to find the "right" price for oil. In reality they are doing the same thing today as they did in 1998 by forcing out the high cost producers and forcing OPEC members to eventually agree to quotas again.

Note that crude prices bounced at the long term trend line.

Active Rigs

Active drilling rigs declined -27 to 905 for the week ended on Friday. Oil rigs declined -24 for the week to 679. Active gas rigs declined -3 to 222. Active rigs have now declined -1,025 since the high of 1,931 in September. That is a -53.1% drop. Active offshore rigs were flat at 34 and well off their January high of 60.

Oil Inventories

Crude inventories rose another 1.9 million barrels to 490.9 million and the highest level for April since 1931. Crude inventories have risen +108.4 million barrels over just the last 16 weeks. Inventories are 23% over year ago levels.

Refinery utilization rose slightly to 91.3% last week from 91.2%. Imports declined from 7.77 mbpd to 7.4 mbpd. U.S. production rose +37,000 barrels to 9.373 mbpd.

Cushing inventories declined -500,000 barrels to 61.7 million. Cushing was over 87.6% of capacity the prior week and well over the level where inflows are normally curtailed in order to maintain operational capability. Cushing has about 71 million barrels of capacity according to the EIA. The highest utilization on record was 91% set in March 2011.

In the graphic below green represents a recent high and yellow a recent low.

Market

The markets traded slightly lower last week with a couple days of heightened volatility. We are into the sell in May period and they could continue to be volatile over the next couple of weeks. Crude prices could also be volatile after a 20% gain in April. It is time for some profit taking but should the dollar continue to decline it would support higher crude prices.